On June 13, 2017, the Internal Revenue Service re-issued regulations that implement a new centralized audit regime for partnerships and limited liability companies taxable for federal income tax purposes as partnerships. The new audit regime is effective for partnership tax years beginning after December 31, 2017.
Current Audit Regime
Under current rules, partnership audits are generally conducted through a unified procedure at the partnership level. A “tax matters partner” serves as the representative of the partnership and corresponds with the IRS during an examination. Partners have certain rights to participate throughout the audit on their own behalf. The IRS may generally make adjustments to partnership items at the partnership level in one proceeding. Once the adjustments are made, the IRS makes corresponding adjustments to each partner’s return. Any taxes, penalties and interest are then assessed and collected from the partners.
New Partnership Audit Rules
Effective for tax years beginning after December 31, 2017, the existing partnership rules are replaced with a new partnership audit regime applicable to all partnerships.
Partnerships are required to designate a “partnership representative.” A partnership representative need not be a partner in the partnership and may be an entity or an individual. A partnership representative is the sole representative of the partnership, and its actions and decisions with respect to the centralized partnership audit regime are binding on both the partnership and its partners. One very important change is that the IRS is no longer required to notify partners of partnership audit proceedings or adjustments and partners no longer have rights to participate in partnership audits or related judicial proceedings or standing to bring a judicial action if the partnership representative does not challenge an assessment.
Partnership-Level Audit Determinations
Under the new rules, any adjustment to items of partnership income, gain, loss, deduction or credit, and any partner’s distributive share thereof, are determined at the partnership level. The tax deficiency arising from a partnership-level adjustment with respect to an audited partnership tax year (the “Imputed Underpayment”) is calculated using the maximum statutory income tax rate and is assessed against and collected from the partnership in the year that such audit (or any judicial review) is completed. The partnership is directly liable for any related penalties and interest, calculated as if the partnership had been originally liable for the tax in the audited year. Importantly, under this regime a newly admitted partner may be liable for a share of the Imputed Underpayment arising in a year prior to that partner’s admission to the partnership.
Election Out of New Rules
Certain small partnerships are eligible to elect out of the provisions for a given taxable year (the “Section 6221 Election”), with the result that any adjustments to such a partnership’s items can be made only at the partner level. This election may be made only by partnerships with 100 or fewer partners, each of which is an individual, a C corporation, an S corporation or an estate of a deceased partner. Thus, for example, any partnership having another partnership or a limited liability company as a partner is not eligible to elect out of the new audit regime.
“Push Out Election”
A partnership may elect to “push out” one or more Imputed Underpayments to its partners in the year being audited rather than pay the Imputed Underpayment at the partnership level and having the current partners bear the costs of such tax (a “Push-Out Election”). If a partnership makes a valid Push-Out Election for a particular year, it will no longer be liable for the Imputed Underpayment and the partners who were partners during that year will be liable for Imputed Underpayment.
Amendments to Partnership Agreements
Entities taxed as partnerships should review and amend their operating agreements to reflect the centralized partnership audit regime. There is no “one size fits all language that can be used to make such amendments.” The types of provisions to be amended include the appointment of a partnership representative and the incorporation into the agreement of the Section 6221 Election and possibly the Push-Out Election. Additional provisions to be considered include the establishment of potential tax reserves, the requirement for partner indemnifications, the requirement for former partners to file amended returns in certain circumstances and certain claw-back provisions.
The new partnership audit rules are extremely complex. We encourage you to contact Kohrman Jackson & Krantz LLP for assistance in reviewing, analyzing and amending operating agreements to reflect the new partnership audit regime.
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